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A thread on the US neutral Fed Funds, and more specifically my two-fold concern that I may have over-estimated it’s level, and how it may decline once again over the coming 12-18 months, with natural implications for UST directionality. 1/
To address the obvious first – why focus on the neutral rate when the Fed says that it is unknowable in advance? The reason is that the neutral rate has mattered a great deal for the UST curve since the mid-1990 and is a lodestar for analysing US rates. 2/
As I have mentioned before, the best way to obtain the mkt’s estimate of the neutral rate is to extract the real yield from the USD 5fwd 5yr inflation swap. I add the Fed’s 2% inflation target to this measure to create the nominal neutral rate. 3/
This mkt measure currently implies a neutral FF rate of 2.69%, down from over 3% a few months back, but still far above the ~2.0% that prevailed in 2015-2016. This implies that the Fed is less than 1 hike from neutral. 4/ 
The gap between neutral & the FF rate is a proxy for how restrictive the Fed is. Intuitively, this helps explain the shape of the UST curve. For all the talk of structural factors driving the UST curves, the neutral rate remains the dominant explanation. 5/
The neutral rate provides and analytical anchor for the level of UST 10s. Given that UST 10s are a sum of expected O/N rates over a 10 yr period (+/- issues such as collateral premium, etc) the level of 10s should be biased to the neutral rate. 6/
This relationship is by no means a trading model, more a sense of gravity. If UST 10s are notably above neutral then this requires an assumption that the neutral rate will rise and/ or that monetary policy can remain restrictive for an extended period. 7/
By contrast, the UST 10s can trade below the neutral rate for an extended period of time if the US economy is believed to require very loose monetary conditions, such as in the post GFC era. 8/
My own view of neutral has been below the mkt’s (which was not much use navigating mkts for much of 2018). I assume neutral is 2.50%, and that this increased from 2.0% in 2016 due to financial sector deregulation and more notably due to fiscal stimulus. 9/
This explains my surprise as UST10s headed to 3.25% a few months back: this was a large spread over the mkt implied neutral rate at that time of 3.0%, while that estimate of neutral was in itself around 50bp too high in my view. Expletives were uttered. 10/
This framework helps explain the rapid pace of the decline in UST 10s since Nov. As this more recent chart shows, not only did UST 10s move back to the neutral rate, but the estimate of neutral itself dropped by ~30bp. A double tail-wind for duration. 11/
Now I come to my concern. The neutral rate is likely to move lower in 2019-2020 as fiscal stimulus fades, esp as fiscal expansion will not have a lasting positive effect on potential US growth. The fiscal stimulus temporarily lifted neutral. 12/
Of greater concern is whether I was too optimistic in assuming a 2.50% neutral rate. The notable weakening of the cyclical, interest rate sectors of the US economy in recent months suggests a higher than expected sensitivity to rates…13/
Maybe the neutral rate did not rise by the 50bp I assumed since 2016? As things stand, I assume that the mkt implied neutral rate means that USTs are centred around a new, lower trading range, and suggests the Fed may be 1 hike from inverting 2s10s. 14/
If my estimate of neutral is correct, then there is the potential for this trading range to move lower still, & for the UST curve to bull flatten. However, if the neutral is indeed lower than 2.50% then the USTs might have much further potential to rally. 15/
My UST view is formed more but the mkt's estimate of neutral than my own. But, the potential of the mkt pricing-in a notably lower neutral rate is a risk to watch esp as TIP real yields remain elevated considering the pricing-out of Fed rate hikes. 16/
And adding a chart which has all of the labels visible as the one in Tweet #6 of this threat was missing a label. Apologies. Also, as ever - apologies for garish colour schemes as I'm colour blind and my charts look tasteful to me and no doubt to me alone.
